The Economics of Cartels
OPEC, one of the world’s most famous cartels, is back at its shady ways, but, thankfully the organization is doomed to fail.
Whenever we hear the term “cartel” there is always a negative connotation involved with its use. We tend to correspond the term with the drug cartels of Mexico and people like “El Chapo,” the leader of the Sinaloa Cartel who escaped a maximum-security prison in July.
Less talked about are groups like taxicab cartels, which have been involved in passive-aggressive disputes with Uber and other ridesharing companies. Well maybe not in France after cab drivers essentially rioted because of Uber. These are just a few examples of cartels, but one that affects our lives quite a bit and has recently engaged in some fishy economics, is the oil cartel, known as the Organization for Petroleum Exporting Countries, (OPEC).
Oil is not only the magic juice that makes our cars run, it essentially makes the world run, which is why some key oil producers banded together to form a cartel.
That Oil Smells Fishy
To find out what the heck the oil cartel is doing that is so fishy, we should probably define a cartel. A cartel is an agreement between competing firms to control prices and exclude other firms from coming into the market. In other words, it sucks if your field of a business has a cartel and you’re not in it.
OPEC’s stated objective is to co-ordinate and unify petroleum policies among Member Countries, in order to secure fair and stable prices for petroleum producers; an efficient, economic and regular supply of petroleum to consuming nations; and a fair return on capital to those investing in the industry. How sweet of them.
OPEC was founded in 1960 when an agreement was signed between the five founding countries: Iran, Iraq, Kuwait, Saudi Arabia, and Venezuela. Currently, OPEC membership consists of Algeria, Angola, Ecuador, Iran, Iraq, Kuwait, Libya, Nigeria, Qatar, Saudi Arabia, United Arab Emirates and Venezuela — all powerhouses in oil production. Member countries all agree to keep prices high enough to make ridiculous profits but low enough that everyone will still go to them for the oil. Part of this is accomplished by setting the production levels of oil for each country.
Economics Say, “Hold the Phone”
If you haven’t noticed, it has been refreshingly cheaper to fill up at the gas pump lately. Since September of last year, the price of crude oil has dropped by fifty percent. That’s huge and I don’t think we’re complaining. Why the drop though
Whipping out the supply and demand model that we all dreaded from our basic economics class, the drop in price is pretty easily explained. The supply of oil has increased throughout the world. When supply increases, prices drop. In order to get rid of the extra supply of oil, you lower the price so people will buy more of it.
In addition to the increased in the supply of oil, we’ve also seen a drop in demand. Energy efficient cars plus alternative energies like natural gas have deterred the demand for oil quite a bit. If you want prices to come back up, just stop producing as much. It’s simple! But it’s a bit different when you add the whole cartel piece.
Oil Cartels and Damn Dirty Pizza Dealers
OPEC doesn’t want to stop producing. They want the non-member countries like Russia and the United States to stop producing as much. So what does OPEC do? They artificially drop the price of oil much farther than necessary while not cutting any production. This doesn’t make sense economically unless you’re just being an asshole. Here is an illustration:
Mario, a pizza shop owner has a chain of stores. To keep this analogy simple, let’s assume Mario only sells whole pizzas, no individual slices. His stores all sell different amounts of pizza, but they all stay at the same price. He pretty much has control of all the pizza sales in the city. You can go to any of the stores and get the pizza for $10.
Now, there are a couple other stores that pop up from different chains. They sell pretty much the same pizza but for $9 per pie. So, reflecting standard consumer behavior, a bunch of pizza lovers decide to get the better deal at the new stores. Meanwhile, Mario’s pizza shops have not stopped producing the same amount of pizzas every day, even if people have stopped coming in to buy them.
Mario is a bit pissed, but since he’s been in the game for a long time, he’s been able to load up on that pizza cash and he’s got stacks and stacks of pizza boxes filled with money. So, just like OPEC, he drops the price of his pizzas to $5. Everybody starts coming back to Mario’s pizza shops and now the competing stores have to drop their prices to compete. Because Mario’s prices are so low, the other pizza joints start losing money and have to lay off workers, cut their production of pizzas, and some even have to get out of the pizza game altogether. Mario’s Pizza is back on top.
Moral of the story, oil is the same as pizza. Because the members of OPEC have agreed to drop prices and keep production up, they are essentially trying to push other producers like Russia and the United States out of the market. It’s a classic case of cartels doing what they do best—screw up the basic principles of supply and demand.
Cartels Suck, but They Are Flimsy Compared to Supply and Demand
Cartels have been around forever. They’ve been around in private, public, and underground industries. Gas companies like BP, Texaco, and several others are part of a cartel. You see drug cartels, taxicab cartels, crude oil cartels, sororities, fraternities, hotels, etc. Although they seem to control the game, we see that many times they can’t withstand the power of simple economics.
Because cartels consist of producers agreeing on how much to produce and at what price as opposed to letting the free market control those factors, they often miscalculate. In addition, these agreements are flimsy in that sometimes, members turn their back on the agreement and do their own thing, making it very dependent on trust.
It seems like cartels monopolize industries, but they usually combust because of the power of the free market. We see the sharing economy disrupting a number of cartelized industries, and the same goes for oil. So as for OPEC, although they might a strong hand in the oil market, a strong hand is weak match for the invisible hand.
#AdamSmith Good riddance, OPEC.